2018 Outlook

When it comes to the global economy, the threat of storm clouds always seems to be hovering overhead. But heading into 2018, investors can see blue skies just about everywhere they look. From reduced political tensions in Europe to reform initiatives in India, to a more stable China, underlying conditions are decidedly upbeat. Indeed, the synchronized global economic recovery is gathering a head of steam.

Much of the good news, however, is reflected in assets prices, as stock and bond markets around the world have delivered positive results for much of the past year. In an environment characterized by healthy underlying growth but relatively high valuations, it is time for balance and flexibility in portfolios. Here are key takeaways and investment implications to consider as you position portfolios for 2018:

KEY TAKEAWAYS

The global economic expansion is gaining momentum, but with valuations rising across most asset classes, selectivity is essential.

The U.S. economy is strong, but markets are expensive. There may still be room to run in Europe and emerging markets. Review asset allocation to consider Europe’s improving health and rising consumer purchasing power in emerging markets.

It may be time to de-risk core bond portfolios and avoid excessive high-yield exposure.

Robert Lind

European Economist

"There is mounting evidence that near-term momentum is building in the global economy and the cycle appears to be self-sustaining, particularly with respect to Europe. The synchronization of global growth has raised the possibility that the cycle can be stronger for longer."

Global Economies Continue to Gain Ground

Among the First to Experience Recovery, U.S Edges Toward Late-Cycle Territory

For illustrative purposes only.

Sources: Capital Group, FactSet. GDP data as at 6/30/17. Country position within the business cycle are estimates by Capital Group economists.

After eight years of steady but modest growth in the U.S., many investors may be concerned that the American economy is nearing the end of the cycle. But don't cue the closing credits yet. Corporate profit growth remains healthy and inflation has been relatively tame. That said, with wages rising look for wage inflation to pick up modestly later in the year.

For much of the rest of the world, it is still early in the cycle. Europe appears to have entered a prolonged period of strength, and the euro-zone economy is expected to grow nearly 2% in 2018, according to the International Monetary Fund (IMF). Meanwhile, the IMF expects 1.5% growth in 2018 for the U.K.

Overall the IMF expects global gross domestic product (GDP) to increase 3.7% in 2018, from 3.6% in 2017, with each of the world's major economies firmly in the growth column.

Market Levels Suggest Better Opportunities Elsewhere

Valuations Point to Relatively Attractive Opportunities Outside the U.S.

Past results are not a guarantee of future results.

Sources: Capital Group, FactSet, MSCI, RIMES, Thomson Reuters. As at 9/30/17. Market capitalization is each country or region's weight within MSCI All Country World Index (ACWI). GDP is each country or region's percentage of total world nominal GDP. Price-to-earnings are as at 9/30/17.

Most of the world's major equity market indexes achieved or neared multiyear highs in 2017, as investors set aside concerns about politics and focused on broadening expansion. European stocks had a strong run in 2017, rising 23% and outpacing U.S. shares for the first time since 2012. Emerging markets equities also outpaced the U.S., soaring 32%.

In fact, market levels suggest that better investment opportunities may continue in non-U.S. markets. Consider that the U.S. accounts for 52% of global market capitalization, near a historic high, and its market cap is 106% of its GDP. Granted, a number of factors justify a relatively higher share of market cap for U.S. companies, as it is the home market for many of the world's dominant companies, and roughly 40% of Standard & Poor's 500 Composite Index company earnings come from overseas.

Also consider that the forward P/E ratio for the U.S. market, at 17.9, is notably higher than other major markets. Conversely, the emerging markets share of global market cap appears relatively modest compared with its contribution to GDP. And, emerging economies are expected to contribute half of global GDP by 2021.

"I am concerned that people are getting very complacent, expecting this low-growth, low-volatility environment to last. In my view the tail risks are increasing the longer it continues. So I am getting more cautious, focusing on unloved investment ideas: anti-momentum stocks with good cash flows and compelling valuations."

Lisa Thompson

Portfolio Manager

Market Volatility Is Low, but Don't Get Too Used to It

Sources: MSCI, RIMES as at 10/11/17. Data represents price returns in U.S. dollars.

Complacency appears to have spread as global equity market volatility has fallen to historically subdued levels. As of October 11, the MSCI ACWI declined by more than 1% on only two days in 2017, the fewest number on record. It also marked the first time since 2005 that there wasn't a single daily decline above 1.5%.

While subdued volatility may be welcome, it cannot continue indefinitely. After all, the world is no less dangerous or uncertain than it was, say, 10 years ago. The possibility of trade skirmishes between the U.S. and China, an unexpected spike in inflation or the remote chance of conflict with North Korea could all trigger higher volatility. Taking elevated valuations into consideration, it is important to guard against complacency, but also be sure not to overreact to inevitable bouts of market volatility.

"Long-term U.S. interest rates should remain range bound unless you get a geopolitical event in places like North Korea or inflation breaks out unexpectedly."

Pramod Atluri

Portfolio Manager

Global Rates Should Stay Low Despite Improving Economies

Higher Relative Yields Should Continue to Support Demand for U.S. Bonds

Past results are not a guarantee of future results.

Source: Thomson Reuters as at 10/31/17.

A number of factors have kept yields low, such as modest economic growth in the U.S., persistently low inflation and strong demand from global investors for U.S. bonds. Long-term rates could rise modestly as U.S. economic growth remains robust and the Federal Reserve has started to trim its balance sheet, which means it will no longer be the largest buyer of bonds. Capital Group's fixed income team expects the benchmark U.S. 10-Year Treasury yield to remain in a 2.25% to 3% range despite a higher policy-driven rate.

Despite these relatively low levels, U.S. interest rates remain higher than many other developed markets, partly because the U.S. economy has sustained a significantly higher growth rate. The higher relative yields in the U.S. relative to other developed markets should continue to support demand for U.S. Treasuries. Meanwhile, against the backdrop of low interest rates in developed economies, demand for higher yielding emerging markets debt has risen substantially. The fixed income team expects this demand to continue. Many emerging markets economies are growing at a steady clip and do not have any significant economic imbalances.

Diversification is key, and a balance between credit and interest rate exposure may be prudent, although at tight valuations, credit can provide a yield spread over government bonds and can add meaningful additional income over time. On the other hand, government bonds, and municipal bonds in the US, can provide valuable diversification from both equities and credit. Meanwhile, emerging market bonds continue to offer value, supported by improving fundamentals.

History Suggests Stock Picking May Rise in Importance in 2018

A rising tide has lifted most ships. Investors could find any number of ways to generate solid returns in 2017. The equity bull market spread across the globe last year, as nearly all of the 47 stock markets that comprise the MCSI ACWI posted gains. This broad upward trend further amplified goes news for U.S. equity markets, which have experienced eight years of solid gains. As a result, valuations are elevated across regions and asset classes.

Careful stock picking will be essential going forward. This conclusion may not be surprising coming from Capital Group. But clearly, given the level of valuations generally, stock prices going forward may be vulnerable to the likelihood of rising volatility. What's more, following years of lengthy risk-on, risk-off periods of investing, equity marked correlations recently have fallen to multiyear lows. Such an environment can be favourable for investment managers with a careful, research-driven approach to stock selection.

What This Means for Portfolios

The synchronized global expansion appears to be entering a period of sustainability, but with volatility at multiyear lows, complacency has spread across markets, and valuations are higher across a range of asset classes. Equities still represent attractive return potential, but at this stage in the cycle, position for resilience during inevitable periods of volatility. Ensure portfolios are well-diversified, with the flexibility to pivot to select areas of opportunity.

Key Takeaways

Soaring consumer confidence, a healthy jobs market and improving retail sales are giving the U.S. economy a further boost.

Faster wage growth and Fed tightening will eventually lead to higher inflation, but generally favorable conditions will likely persist in 2018.

After years of solid market returns, valuations for most U.S. assets are at or near multiyear highs, so at this stage of the cycle a measure of caution is warranted.

“The U.S. economy seems to be chugging along nicely, and I don’t see much on the horizon to be concerned about other than higher equity valuations. We have had market appreciation for nearly a decade now, so I think it will increasingly be a stock-pickers' market”.

Hilda Applbaum

Portfolio Manager

U.S. Economic Engine Reaches a Higher Gear

Consumer Strength, Modest Inflation Point to an Extended Expansion

Sources: Bureau of Economic Analysis, Bureau of Labour Statistics, Thomson Reuters. GDP growth is the year-over-year growth in 3Q16 and 3Q17. Inflation and retail sales growth are year-over-year changes on 9/30/17 and 9/30/16. Inflation uses the change in the consumer price index. Jobs added is the monthly change in the payroll survey as at 10/31/17 and 10/31/16. Manufacturing activity is the manufacturing component of the 9/30/17 and 9/30/16. Institute of Supply Management (ISM) Purchasing Managers' Index (PMI) reports.

When it comes to the U.S. economy, good news seems to be getting better. Growth hasn’t been robust during the current cycle, but it has been steady. And it appears to be entering a new phase of self-sustaining equilibrium. Gross domestic product (GDP) rose at a 3% annual rate in the third quarter of 2017, the second consecutive quarter of 3% growth. At more than 100 months old, the expansion is mature, but the absence of notable imbalances indicates it can continue for some time. But markets have been soaring of late and valuations are high across asset classes, pointing to the importance of selective investing.

U.S. growth appears poised to strengthen further, thanks largely to consumer health. The jobs market is solid, consumer confidence is soaring and retail sales growth is picking up. The U.S. employment rate fell to 4.1% in October, a 17-year low. As a result, wages have also been picking up, rising 2.4% in October. Thus far wage growth has been subdued, helping keep a lid on inflation. But given the improving jobs market and strengthening economy, wage inflation is likely to rise later in the year.

Consumer spending on durable goods rose at an 8.3% annual rate in the third quarter, and capital expenditures rose 7.4%, providing an additional tailwind to the economy. In addition, corporate profits rose 5.8% in the third quarter. On the policy front, the prospect of corporate and personal income tax cuts could propel the expansion further.

With consumer spending healthy and wages rising, consumer-facing businesses have the potential to do well in the next phase of the economic expansion. Companies across a wide variety of industries are exposed to rising consumption, including home improvement retailers such as The Home Depot, online retailer Amazon and emerging market giant Alibaba.

U.S. equity markets have been soaring. Since 2009, total returns for the S&P 500 have averaged nearly 19.2% annually through October 2017. As a result equity markets have touched all-time highs and valuations are quite elevated. But stocks aren’t the only expensive asset class. High-yield and corporate bond returns too have been robust, leaving credit spreads at their tightest levels in years. Conditions remain favorable and markets tend to climb a wall of worry, so the rally could continue. But the rising tide can’t lift all ships forever. At this stage of the cycle, caution and selectivity are essential.

“In my view the U.S. is priced for perfection, so I am taking a more cautious approach, gravitating to areas that I believe can hold up better in choppier markets, like select financial companies. Financials have substantially increased their capital base, they have been conservative in their lending and the interest rate cycle is favorable to them.”

Greg Johnson

Portfolio Manager

Dig Deeper to Uncover Potential Value

A Look Beneath Market Averages Reveals Differentiation

Past results are not a guarantee of future results.

Returns in USD terms.

Sources: RIMES, Standard & Poor's as at 9/30/17

The U.S. stock market has soared since the end of the global financial crisis, reaching its prior peak in 2012 and more than doubling since then. But not all areas of the market have reached elevated heights at the same time. The stunning gains of a number of the largest technology and consumer discretionary companies such as Alphabet, Amazon, Apple and Facebook had much attention – gains that can be partly justified by dominant competitive positions and robust growth rates.

Financials recently reached its pre-recession peak after 10 years and energy has returned to 2007 levels. The global financial crisis generally hit financials stocks the hardest, and the sector declined nearly 80% following its peak in May 2007. Given the sector’s slower recovery, it may still have more room to run. Further U.S. Federal Reserve (Fed) interest rate hikes could provide another boost to the industry. With respect to both financials and energy, select companies are likely to fare better than others, so fundamental research will be key to identifying potential winners.

The potential for credit growth driven by solid consumer fundamentals, and the prospect of rising interest rates, could help drive profit growth for banks. Regional bank PNC Financial Services and conglomerates JPMorgan Chase and Wells Fargo are examples of companies that have strong credit card and commercial banking divisions.

What This Means for Portfolios

With most asset valuations near multiyear highs, volatility at multiyear lows and profits near record levels, a measure of caution is important. Invest selectively, focusing on companies with attractive valuations in areas where value is unrecognized by the market. Consider rebalancing from U.S. toward international and emerging market equities.

Key Takeaways

Improving economic growth in Europe and Japan, coupled with attractive valuations and a weak dollar, have produced the most encouraging outlook for global investing in years. Investor sentiment has soared as political uncertainty diminished.

Global equities are outpacing U.S. equities for the first time in nearly a decade. That trend may continue as Europe and Japan have taken longer to recover from the global financial crisis and, therefore, potentially have more room to run.

The European Central Bank and Bank of Japan continue to inject massive amounts of stimulus into their respective economies, priming the pump for additional growth and inflation in the years ahead.

“Among developed economies, Europe looks like the best place to invest right now. We are seeing a broad-based recovery across the continent, particularly in countries that have engaged in fiscal reform over the past few years.”

Mark Denning

Portfolio Manager

As Global Economy Gathers Strength, Europe is Looking Up

Economy, Markets and Corporate Profits Are All Headed in the Right Direction

+14%

MSCI Europe Total Return (2017 YTD) Highest annual return since 2013

+14%

Earnings Growth (3Q17) Fastest growth since 2011

+2.5%

GDP Growth (3Q17) Fastest growth since 2011

Past results are not a guarantee of future results.

Sources: FactSet, MSCI, RIMES, Thomson Reuters. Total return is in local currencies as at 10/31/17.

Europe has enjoyed a remarkable recovery in recent months, driven by a powerful combination of central bank stimulus, ultra-low interest rates and improving growth. But perhaps the most important influence on investor sentiment is what didn’t happen in 2017: the European Union didn’t collapse under the weight of the nationalist, anti-EU movement that had posed a significant threat during a year that featured pivotal elections in France and Germany.

If anything, the future of the 28-nation economic union looks stronger now that it has in years, despite the U.K.’s expected departure in 2019. Fears that France, Italy and Greece might follow the U.K.’s Brexit path have dissipated as continental Europe has essentially lined up in support of the EU’s governing authority. As a result, the euro has strengthened against the dollar and Europe has enjoyed a surge of financial asset inflows.

Meanwhile, euro-zone economic growth is gradually catching up to the U.S. Third-quarter GDP in the 19-member euro zone grew at an annualized rate of 2.5%, and the unemployment rate has fallen to 8.9%, its lowest level since 2009. Moreover, corporate earnings are up across the board, led by a strong rebound in the energy, mining and banking sectors, thanks in part to the strengthening global economy.

Europe and Its Factories Are Back in Business

31 of 32 Countries Tracked Are in Expansion Territory

Sources: Capital Group, Haver as at 9/30/17. The Purchasing Managers' Index is an indication of whether business conditions for a number of variables in the manufacturing sector have improved, deteriorated or stayed the same compared to the previous month. An index reading above 50 indicates an expansion, whereas a reading below 50 indicates a contraction.

Europe’s manufacturing activity – previously a weak point on the region’s path to recovery – has increased dramatically, supported by rising orders for everything from new aircraft to highly sophisticated technology components. In fact, many euro-zone factories have reported labor shortages amid the surging demand. Factory activity has expanded in all major European nations, led by manufacturing powerhouse Germany and neighboring Netherlands.

Despite these encouraging signs, however, the European economy continues to struggle with deflationary pressures. Core inflation, excluding volatile food and energy prices, fell to 0.9% in October, its lowest level since March and far below the European Central Bank’s 2% target. This persistently weak trend prompted the ECB to extend its massive bond-buying stimulus program through September 2018 in an attempt to boost lending and support further economic growth.

Thanks to improving global growth, select European companies are thriving — particularly those that operate on a global stage. Dutch semiconductor equipment-maker ASML, for instance, has continued to exceed earnings expectations, benefiting from soaring demand for computer chips used in mobile devices. The so-called ‘Internet of Things’ investment theme is alive and well in Europe, powered in part by Dutch technological innovation.

“While we may see short-term periods of U.S. dollar strength now and then, my view is that the dollar will continue its downward trajectory over the course of 2018 and into 2019, providing a further boost to international investing.”

Jens Søndergaard

Currencies Analyst

Is the Dollar Bull Run Over?

Longer term, look for extended strength in non-U.S. currencies

Past results are not a guarantee of future results.

Sources: RIMES, Thomson Reuters as at 10/31/17.

Factory activity has expanded in all major European nations, led by manufacturing powerhouse Germany and the neighboring Netherlands. After the dollar peaked in early 2017, it has been on a weakening trend against the euro and the yen.

Investors should keep a close eye on this trend, however. Improving U.S. economic growth, gradually rising U.S. interest rates and the European Central Bank’s stimulus-program extension combined to push the dollar higher in September and October. Capital Group currencies analyst Jens Søndergaard believes this near-term dollar strength will fade, and that the dollar will continue its decline through 2018 and 2019.

In the financials and industrials sectors, a valuation gap has emerged between some European and U.S. companies. Airbus and Barclays, for example, have recently traded at significant valuation discounts to comparable companies in the United States. The gap has started to close in other sectors as European equities have rallied, but these two sectors remain areas of potential opportunity for value-oriented investors.

What This Means for Portfolios

After years of lagging U.S. stock market returns, many European and Japanese companies remain attractively valued. Seek meaningful exposure to Europe and Japanese companies that stand to benefit from a strengthening global economy.

Key Takeaways

Emerging markets stocks delivered impressive returns in 2017, but valuations for many companies domiciled in developing nations still appear relatively attractive and profit growth is surging, suggesting there is room to run.

Stronger local currencies in some nations, an expanding global economy and rising middle class prosperity also bode well for emerging markets stocks.

At this stage of the rally, with market expectations rising and the prospect of tighter central bank policies across major markets increasing, selectivity is essential.

"The stability and reform we are seeing in places like China and India are resulting in greater investment opportunities. It's not just obvious areas like Indian banks and Chinese internet companies, but I am also interested in domestic industries like cement and power, as well as retail companies and consumer-orientated businesses."

Chris Thomsen

Portfolio Manager

Emerging Markets Stocks Have Only Just Begun Making Up Ground

Rising Middle Classes, Increased Consumption and Automation Suggest Developing World Has Room to Run

The rally in emerging market equities is more than 20 months old, with stocks up 70% since a trough in early 2016. Is the rebound getting long in the tooth? It really could just be getting started. An expanding global economy, strengthening currencies and robust demand for technology-related components all bode well for emerging markets. A synchronized global recovery is an ideal environment for emerging markets, similar to the period that lasted from 2003 to 2007.

Amid the ongoing rebound, overall valuations are still attractive from a historical basis and compared to developed markets. For instance, China, Taiwan and Brazil all trade around 13 times projected earnings over the next year, compared with 17 times estimated earnings for the MSCI World Index. Company cash flows are also increasing, which could lead to higher earnings revisions. Corporate profits are forecast to climb 13% in 2018, and historically rising profits have been good for share prices.

An improving global economy and dollar weakness can be tailwinds for companies in a broad range of industries, from information technology to consumer goods to financials and commodities exporters. For example, Chinese internet giants Tencent and Alibaba are positioned to benefit from rapid growth in mobile commerce and financial services. Banks with solid consumer lending businesses also stand to benefit from stronger global growth.

“In today’s emerging markets, there are some very strong technology companies that deliver e-commerce services in a very efficient fashion and the adoption rate is high. Chinese internet businesses are now leading innovation in financial services and other areas, a divergence from the past.”

Shaw Wagener

Portfolio Manager

China Deftly Manages Economic Transition

Overall GDP Has Slowed, but Consumption Growth Is Still Accelerating

In percentages. Source: Thomson Reuters as of 9/30/17.

There seems to be no shortage of worries about China, ranging from debt levels at state-owned enterprises to a potential trade war with the U.S. to an overheated real estate market. That said, China appears to be deftly managing its economic transition to a services-led economy, sidestepping a much feared hard landing through targeted stimulus measures and moves to curb capital flight.

President Xi Jinping enters his second five-year term with a firmer grip on his power and control over the direction of the economy. Measures on Xi’s agenda include consolidating heavy industries, curbing pollution, managing financial risks and supporting technological innovation.

Consuming remains brisk. Housing demand is strong despite government restrictions aimed at curbing speculation. Home purchases should support consumer spending in areas such as household appliances and furniture. Meanwhile, internet heavyweights Tencent and Alibaba continue to report robust sales and profit as consumers gravitate to their wide-encompassing mobile services platforms.

The Chinese corporate sector looks to be in good shape. While Chinese stocks have surged over the last 12 months and valuations have risen, forward earnings expectations are rising on an unexpected recovery in cyclical industries. Profit forecasts are further supported by improving cash flows and debt service ratios. In China’s current economic and political climate, the kinds of companies that could thrive are select technology firms, health care providers and financial services companies.

What This Means for Portfolios

Maintain exposure to emerging markets companies poised to benefit from rising consumer purchasing power and broader adoption of technology. But be prepared for elevated volatility.

Signs of Maturity in Emerging Markets

As the Market Has Shifted from Commodities to Tech, Volatility Has Declined

Emerging markets have shifted from smokestacks to smartphones. Back in 2008, energy and materials companies dominated the MSCI Emerging Markets Index with a 38% weighting, and many of these firms were state-owned enterprises that were more susceptible to infrastructure-driven booms and busts.

Chinese technology-related firms are now the biggest companies by market value in emerging markets as mobile phone usage is accelerating and internet penetration rates are rising. Along with middle class growth, these developments are changing consumption patterns and delivery methods for financial services.

This “tech-tonic” shift over the past decade (information technology now accounts for 28% of index weight) has also come with a decrease in volatility as cyclical, commodity-oriented companies are no longer index heavyweights.

Look for growth in the technology sector to be driven further by demand for handheld electronic devices and mobile-focused services among the large populace of China and India. Some Asian companies, including Taiwan Semiconductor and Samsung Electronics, have also developed specialized knowledge in areas of semiconductors and are key cogs in the global technology supply chain.

China Deftly Manages Economic Transition

Overall GDP Has Slowed, but Consumption Growth Is Still Accelerating

In percentages. Source: Thomson Reuters as of 9/30/17.

There seems to be no shortage of worries about China, ranging from debt levels at state-owned enterprises to a potential trade war with the U.S. to an overheated real estate market. That said, China appears to be deftly managing its economic transition to a services-led economy, sidestepping a much feared hard landing through targeted stimulus measures and moves to curb capital flight.

President Xi Jinping enters his second five-year term with a firmer grip on his power and control over the direction of the economy. Measures on Xi’s agenda include consolidating heavy industries, curbing pollution, managing financial risks and supporting technological innovation.

Consuming remains brisk. Housing demand is strong despite government restrictions aimed at curbing speculation. Home purchases should support consumer spending in areas such as household appliances and furniture. Meanwhile, internet heavyweights Tencent and Alibaba continue to report robust sales and profit as consumers gravitate to their wide-encompassing mobile services platforms.

The Chinese corporate sector looks to be in good shape. While Chinese stocks have surged over the last 12 months and valuations have risen, forward earnings expectations are rising on an unexpected recovery in cyclical industries. Profit forecasts are further supported by improving cash flows and debt service ratios. In China’s current economic and political climate, the kinds of companies that could thrive are select technology firms, health care providers and financial services companies.

What This Means for Portfolios

Maintain exposure to emerging markets companies poised to benefit from rising consumer purchasing power and broader adoption of technology. But be prepared for elevated volatility.

The global economic environment is improving. Growth is running modestly above trend across many countries and regions, a phenomenon that has not occurred in many years. We have to look to periods before the global financial crisis of 2007–08 to find an expansion this broad-based. However, fixed income markets may be too optimistic that these favorable conditions can continue for an extended period.

In our view, the global economy must continue to operate in this narrow band of “just right” to support current credit market valuations that remain elevated. Should growth momentum accelerate and break out above recent ranges, this would likely trigger more aggressive policy responses by global central banks. The resulting tighter monetary policy, delivered via higher policy rates and a faster withdrawal from quantitative easing, would likely hamper growth.

Key Takeaways

We expect U.S. interest rates to remain range-bound with the 10-year Treasury yield hovering in the range of 2.25% to 3%.

Even as they tighten the monetary policy, the bias of central banks remains supportive of economic growth.

With inflation muted and growth rates modest, we expect the Fed will take a gradualist approach.

"The Fed started reducing the size of its balance sheet in October and I would expect U.S. financial conditions to tighten as a result. With global central bank balance sheets set to decline in late 2019, for me it is a question of when markets will start to get concerned.”

Ritchie Tuazon

Portfolio Manager

Amid Shifting Policy, Rates Should Remain Relatively Low

Look for 10-Year Treasury Yields to Oscillate Between 2.25% and 3.0%

Past results are not a guarantee of future results.

Sources: Federal Reserve, Thomson Reuters. As at 9/30/17.

Long-term interest rates in the U.S. and much of the developed world remain at low levels. In the U.S., a number of factors have kept yields low, such as modest economic growth, persistently low inflation and strong demand from global investors for U.S. bonds. Long-term rates could rise modestly as U.S. economic growth remains robust and the Fed has started to trim its balance sheet, which means it will no longer be the largest buyer of bonds. Capital Group's fixed income team expects the benchmark U.S. 10-Year Treasury yield to remain in a 2.25% to 3% range even though policy-driven rates are rising.

Despite the low level of yields on a historical basis, U.S. interest rates remain higher than many other developed markets, partly because the U.S. economy has sustained a significantly higher growth rate. The higher yields in the U.S. relative to other developed markets should continue to support demand for U.S. Treasuries. Meanwhile, against the backdrop of low interest rates in developed economies, demand for higher yielding emerging markets debt has risen substantially. The fixed income team expects this demand to continue.

Central Banks Take Gradual Approach to Tapering

Financial Conditions Should Not Tighten Dramatically

Since the financial crisis, central banks have expanded their balance sheets to unprecedented levels. These banks became the largest buyers of bonds and other securities as a way of increasing money supply to boost struggling economies. The four major central banks increased securities held on their books from around $4 trillion in 2007 to about $15 trillion in 2017. Now, as the global economy improves, some of them are beginning to move in the other direction. The Fed began shrinking its balance sheet in October. The European Central Bank signalled it will begin to trim its purchases of securities starting in January. With the Fed stepping away from its role as the largest buyer of securities, the risk of a modest rise in yields cannot be ruled out. The Bank of Japan is likely to nudge rates up next year, but significant rate normalization is probably still years away.

As financial conditions tighten, credit assets and mortgage-backed securities remain vulnerable. Investors should maintain a balance between interest rate and credit exposure. Within credit, consider moving up in credit quality so that portfolios can withstand a period of potential market volatility.

“With inflation running below the Fed's target and the economy growing at a modest pace, I think the Fed will take a gradualist approach to raising rates.”

John Queen

Portfolio Manager

Fed Rate Hikes Don't Have to Translate to Bond Losses

In Periods of Rising Rates, Higher Income Can Help to Keen Returns Positive

Past results are not a guarantee of future results.

Returns in USD terms

Sources: Bloomberg Index Services Ltd., Federal Reserve. Data through 9/30/17. Daily results for the index are not available prior to 1994. For those earlier periods, returns were calculated from the beginning of the month containing the first hike through the end of the month containing the final hike.

As the Fed continues on a path of gradually raising interest rates, many investors are moving to cash, short-term bonds and floating-rate securities. But the view that bonds have to suffer losses when short-term rates rise is a misconception. Looking at the past seven periods of interest rate hikes, including the current period, investment-grade bonds (BBB/Baa and above) have generally delivered positive returns, as can be seen from results for the Bloomberg Barclays U.S. Aggregate Index.

If rate hikes are gradual, interest earned by bonds can overcome the price impact to deliver a positive return. Indeed, since the Fed began on its current course of rate hikes, the index has gained nearly 6%, even as the Fed funds target has risen by 100 basis points. The Fed has signaled that it will maintain a gradual pace in rising rates and tightening monetary policy. Against this backdrop, interest rates will likely remain range bound.

Investment-grade and high-yield credit valuations continue to hover near historically tight levels not seen since the period before the 2007 financial crisis. In the market environment of range-bound long-term rates and tight credit spreads, investors should consider holding well-diversified core fixed income portfolios that do not take excessive credit risk. Credit-heavy strategies have performed well as stocks have soared, but they could suffer losses should stock markets reverse.

What This Means for Portfolios

It's important to remain diversified and be careful of excessive high-yield exposure in the search for yield. Credit remains attractive but requires selectivity, some duration looks attractive, and emerging market bonds deserve a closer look

Positive Bond Portfolios for Higher Volatility

Global Growth Is Improving, but Markets May Underestimate Uncertainties and Possible Shocks

Dial units are: duration for U.S. rates, curve. Treasury-Inflation Protected Securities and non-U.S. bonds: percentage of total market value for mortgage-backed securities and foreign currencies; and duration times spread (DTS) for credit. Dial ranges represent minimum and maximum under/overweights that the Portfolio Strategy Group would be willing to consider.

DURATION

YIELD CURVE

X

Capital’s Portfolio Strategy Group (PSG) continues to believe in a "lower for longer" thesis regarding the future level of interest rates. Modest global growth and inflation, as well as the attractiveness of U.S interest rates in a global context, are a few factors contributing to this view. However, current consensus expectations for the path of short-term interest rates are more conservative than the PSG view.

X

Although the Fed is tightening monetary policy, the bias of central banks remains supportive of economic growth. In this environment, the fixed income group thinks the yield curve could steepen and long-term interest rates may rise somewhat more than intermediate rates.

DURATION

Capital’s Portfolio Strategy Group (PSG) continues to believe in a "lower for longer" thesis regarding the future level of interest rates. Modest global growth and inflation, as well as the attractiveness of U.S interest rates in a global context, are a few factors contributing to this view. However, current consensus expectations for the path of short-term interest rates are more conservative than the PSG view.

YIELD CURVE

Although the Fed is tightening monetary policy, the bias of central banks remains supportive of economic growth. In this environment, the fixed income group thinks the yield curve could steepen and long-term interest rates may rise somewhat more than intermediate rates.

INFLATION

CREDIT

X

In light of our view that inflation will continue to rise modestly, particularly in the U.S.

X

High credit valuations suggest caution, given stable to declining fundamentals. Although we do not expect a material rise in defaults for high-yield corporations, minimal allocations are appropriate to high-yield in core bond portfolios.

INFLATION

In light of our view that inflation will continue to rise modestly, particularly in the U.S.

CREDIT

High credit valuations suggest caution, given stable to declining fundamentals. Although we do not expect a material rise in defaults for high-yield corporations, minimal allocations are appropriate to high-yield in core bond portfolios.

Past results are not a guarantee of future results. Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. The information provided is intended to highlight issues and not to be comprehensive or to provide advice. This information has been provided solely for informational purposes and is not an offer, or solicitation of an offer, or a recommendation to buy or sell any security or instrument listed herein.